Macroeconomics

Asymmetric information is a problem which faces managers of firms everywhere. It occurs where one party to a transaction has more information than the other party to said transaction. This of course creates other problems for the managers as well. We can identify four main areas where asymmetric information causes problems. The problems caused are adverse selection, moral hazard, hiring practices and insider trading. This essay will follow the structure of firstly defining and further explaining each of these topics and what affect each has on the manager. We will then move onto possible solutions for these problems, which include screening, signalling and government intervention. Finally in this essay each of these solutions will be critically evaluated to show which of these is best suited for each problem created by asymmetric information.

Adverse selection is what occurs due to asymmetric information before the transaction actually takes place. It occurs due to a type of asymmetric information called hidden characteristics. Hidden Characteristics are things that one party to a transaction knows about itself but which are unknown by the other party (Baye, 2000). Adverse selection is a situation where a selection process ends with only those with undesirable characteristics left. Probably the best example of adverse selection is car insurance. Let us assume that there are two types of poor drivers, those that are just bad drivers and those that are just purely unlucky. This explains why there are some good drivers who have huge premiums or just can't get car insurance. The insurance company cannot determine which of the drivers have bad driving habits and which have only had a string of bad luck accidents. Therefore for the insurance company to insure those with poor driving records they must charge extra high premiums. This leads to adverse selection, as only the drivers who know that they are likely to have an accident due to their bad driving will be willing to pay the higher rate. Therefore the unlucky good drivers will not be willing to pay the higher rate and the insurance company will end up with only those who are likely to wreck their cars. This means that the insurance company has adverse selection due to hidden characteristics. Insurance generally works when there are some drivers who don't wreck their cars, so the insurance company would be well advised to lower the premiums and not insure the drivers with poor records. Health insurance is another good example, as the company may charge premiums based on the average risk of people getting sick. This will probably lead to those who are of poorer health, or a higher risk of getting sick being over represented among its clients. Of course one of the main problems of the hidden characteristics is that even if there is only the suspicion of hidden characteristics, one party may refuse to enter into the transaction. Also when buyers in a market can only observe average quality, there is a tendency for sellers not fully rewarded for high quality to withdraw from the market (Hirshleifer, 1989) Hence the market is left with those lower quality sellers.

Moral hazard is the consequence of asymmetric information that generally occurs after the transaction has been entered into. It results from hidden action, that is, actions that parties to a transaction may take after they have agreed to execute a transaction. Moral hazard is the situation where one party to a contract has an incentive to act in a manner that benefits itself but at the expense of the other party, after the contract is agreed. One of the best examples of moral hazard is when somebody takes out insurance against fire damage. If the premiums reflect the average threat of fire, there can be incentive for the insured to be less cautious and sometimes even deliberately cause a fire. Another example of moral hazard is that of the principal-agent problem. In this case the manager of a firm has a hidden action, his/her effort at work. This is because the manager's effort is unobservable to the owner. This is mainly a problem when the manager is paid a set salary as there is no chance of economic loss; hence there is more of an incentive to put in less effort. Therefore, the fixed salary together with the managers hidden actions result in a moral hazard. Solutions to this will be discussed later.

Asymmetric information can also lead to the hiring of less productive employees. In this case, job applicants have more information about their own abilities than the prospective employers. The applicants will then try to send signals to their employer about their individual qualities and show such things as educational qualifications, previous employment record and current wage if employed. Firms prefer not to hire workers then find they need to fire those with lower productivity. Firms may also invest considerable resources in training a new employee only to find out that he/she is not up to par.

One of the more severe types of asymmetric information is that of insider trading. In the presence of asymmetric information, many buyers refuse to purchase from sellers out of fear that the seller is trying to get rid of the product because it is worth less than they are willing to pay. This can lead to a complete market collapse. Insider trading occurs when someone knows more information about a company in the stock market than the public does. If, for instance, a company finds a cure for a disease the stock price is going to rise as soon as it is announced. If a company insider knows that the announcement is not for a while they may but a lot of the stock at the lower price and then sell after the price goes up, making a lot of money. If there are too many insiders trading at once this may make outsiders not want to be a part of the market as there is no way for them to be profitable. This of course could lead to a complete stock market crash. This is one definite reason why it is important for there to be some solutions to this problem of asymmetric information.

One of the first solutions is that for the insider trading problem and other asymmetric information problems is that of government intervention. For the problem of insider trading there is actually specific laws prohibiting it, and there are very large penalties against those who perpetrate it, as shown by that against Rene Rifkin. Another government policy used to reassure consumers and alleviate asymmetric information is that certification. This is to show consumers that a certain tradesman, product or institution adheres to a certain